Aggregate Demand and

Aggregate Supply
1

Economic activity fluctuates from year

to year.

In most years production of goods and

services rises.
In some years normal growth does not
occur, causing a recession.

Economic fluctuations are irregular and

unpredictable.

Fluctuations in the economy are often

called the business cycle.

Most macroeconomic variables fluctuate

together.
Most macroeconomic variables that
measure some type of income or production
fluctuate closely together.
Example income, corporate profits, consumer
spending, investment, industrial production,
retail sales and so on.
Although many macroeconomic variables
fluctuate together, they fluctuate by
different amounts.

As output falls, unemployment rises.

Changes in real GDP are inversely related

to changes in the unemployment rate.
During times of recession, unemployment
rises substantially.

Two variables are used to develop a

model to analyze the short-run
fluctuations.

The economys output of goods and

services measured by real GDP.
The overall price level measured by the CPI
or the GDP deflator.

The Basic Model of Aggregate Demand

and Aggregate Supply

Economist use the model of aggregate

demand and aggregate supply to explain
short-run fluctuations in economic activity
around its long-run trend.

The Basic Model of Aggregate Demand

and Aggregate Supply

The aggregate-demand curve shows the

quantity of goods and services that
households, firms, and the government
want to buy at each price level.

The Basic Model of Aggregate Demand

and Aggregate Supply

The aggregate-supply curve shows the

quantity of goods and services that firms
choose to produce and sell at each price
level.

Price
Level

Aggregate
supply

Equilibrium
price level

Aggregate
demand

Equilibrium
output

Quantity of
Output
10

Copyright 2004 South-Western

The four components of GDP (Y)

contribute to the aggregate demand for
goods and services.
Y = C + I + G + NX

11

Price
Level

P2
1. A decrease
in the price
level . . .
0

Aggregate
demand
Y

Y2

Quantity of
Output

2. . . . increases the quantity of

goods and services demanded.
12

Copyright 2004 South-Western

The Price Level and Consumption: The

Wealth Effect
The Price Level and Investment: The
Interest Rate Effect
The Price Level and Net Exports: The
Exchange-Rate Effect

13

The Price Level and Consumption: The

Wealth Effect

A decrease in the price level makes

consumers feel more wealthy, which in
turn encourages them to spend more.
This increase in consumer spending means
larger quantities of goods and services
demanded.

14

The Price Level and Investment: The

Interest Rate Effect

A lower price level reduces the interest

rate, which encourages greater spending
on investment goods.
This increase in investment spending
means a larger quantity of goods and
services demanded.

15

The Price Level and Net Exports: The

Exchange-Rate Effect

When a fall in the INDIA price level causes

INDIAs interest rates to fall, the real
exchange rate depreciates, which
stimulates INDIAs.net exports.
The increase in net export spending means
a larger quantity of goods and services
demanded.
16

The downward slope of the aggregate

demand curve shows that a fall in the
price level raises the overall quantity of
goods and services demanded.
Many other factors, however, affect the
quantity of goods and services
demanded at any given price level.
When one of these other factors changes,
the aggregate demand curve shifts.
17

Shifts arising from

Consumption
Investment
Government Purchases
Net Exports

18

Price
Level

P1

D2
Aggregate
demand, D1
0

Y1

Y2

Quantity of
Output

19

In the long run, the aggregate-supply

curve is vertical.
In the short run, the aggregate-supply
curve is upward sloping.

20

The Long-Run Aggregate-Supply Curve

In the long run, an economys production

of goods and services depends on its
supplies of labor, capital, and natural
resources and on the available technology
used to turn these factors of production
into goods and services.
The price level does not affect these
variables in the long run.

21

Price
Level
Long-run
aggregate
supply
P

P2

2. . . . does not affect

the quantity of goods
and services supplied
in the long run.

1. A change
in the price
level . . .
0

Natural rate
of output

Quantity of
Output
22

Copyright 2004 South-Western

The Long-Run Aggregate-Supply Curve

The long-run aggregate-supply curve is

vertical at the natural rate of output.
This level of production is also referred to
as potential output or full-employment
output.

23

In the short run, an increase in the

overall level of prices in the economy
tends to raise the quantity of goods
and services supplied.
A decrease in the level of prices tends
to reduce the quantity of goods and
services supplied.

24

Price
Level
Short-run
aggregate
supply
P

P2
2. . . . reduces the quantity
of goods and services
supplied in the short run.

1. A decrease
in the price
level . . .

Y2

Quantity of
Output
25

Copyright 2004 South-Western

The Misperceptions Theory

The Sticky-Wage Theory
The Sticky-Price Theory

26

The Misperceptions Theory

Changes in the overall price level

temporarily mislead suppliers about what
is happening in the markets in which they
sell their output:
A lower price level causes misperceptions
about relative prices.

These misperceptions induce suppliers to

decrease the quantity of goods and services
supplied.
27

The Sticky-Wage Theory

Nominal wages are slow to adjust, or are

sticky in the short run:

Wages do not adjust immediately to a fall in the

price level.
A lower price level makes employment and
production less profitable.
This induces firms to reduce the quantity of
goods and services supplied.

28

Prices of some goods and services adjust

sluggishly in response to changing
economic conditions:

An unexpected fall in the price level leaves

some firms with higher-than-desired prices.
This depresses sales, which induces firms to
reduce the quantity of goods and services they
produce.

29

Shifts arising

Labor
Capital
Natural Resources.
Technology.
Expected Price Level.

30

Price
Level
Long-run
aggregate
supply

Short-run
aggregate
supply

Equilibrium
price

Aggregate
demand
0

Natural rate
of output

Quantity of
Output
31

Copyright 2004 South-Western

2. . . . causes output to fall in the short run . . .

Price
Level
Long-run
aggregate
supply

Short-run aggregate
supply, AS
AS2
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .

P
B

P2
P3

1. A decrease in
aggregate demand . . .

Aggregate
demand, AD
AD2
0

Y2

Y
4. . . . and output returns
to its natural rate.

Quantity of
Output
32

Copyright 2004 South-Western

Shifts in Aggregate Demand

In the short run, shifts in aggregate

demand cause fluctuations in the
economys output of goods and services.
In the long run, shifts in aggregate demand
affect the overall price level but do not
affect output.

33

An Adverse Shift in Aggregate Supply

A decrease in one of the determinants of

aggregate supply shifts the curve to the
left:

Output falls below the natural rate of

employment.
Unemployment rises.
The price level rises.

34

1. An adverse shift in the shortrun aggregate-supply curve . . .

Price
Level
Long-run
aggregate
supply

AS2

Short-run
aggregate
supply, AS

P2

A
P
3. . . . and
the price
level to rise.
Aggregate demand
0

Y2

2. . . . causes output to fall . . .

Quantity of
Output
35

Copyright 2004 South-Western

Stagflation

Adverse shifts in aggregate supply cause

stagflationa period of recession and
inflation.

Output falls and prices rise.

Policymakers who can influence aggregate
demand cannot offset both of these adverse
effects simultaneously.

36

Policy Responses to Recession

Policymakers may respond to a recession

in one of the following ways:

Do nothing and wait for prices and wages to

adjust.
Take action to increase aggregate demand by
using monetary and fiscal policy.

37

1. When short-run aggregate

supply falls . . .
Price
Level
Long-run
aggregate
supply

P3

P2
3. . . . which P
causes the
price level
to rise
further . . .
0

4. . . . but keeps output

at its natural rate.
Natural rate
of output

Short-run
aggregate
supply, AS

AS2

2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .
AD2
Aggregate demand, AD
Quantity of
Output
38

Copyright 2004 South-Western